In this issue of TraderSavvy:

- Are you an Insider? Get our Futures & Options Guide
- Interested in Options? Check out our Secrets!
- Learn to trade options with Trade Learner!

View additional market commentary on

In This Issue:
Steve Salman talks about discovering the mathematical advantage of selling options.
July 1 , 2008
Sponsored By:




Advertise with us

Published By InsideFutures






Are you an Insider?
Get our Futures
& Options Guide





Interested in Options? Check out our Secrets!





Learn to trade options
with Trade Learner!

The Option Selling Strategy
By Steve Salman of Opvest Option Investments Inc.

Option selling in commodities, if done properly, can provide many advantages over traditional investments. Statistically, according to the Chicago Mercantile Exchange, it is estimated over 80% of the short term, out-of the money commodity options expire worthless. If you are a buyer of options, the odds of making money are against you because, in addition to the need to pick the correct market direction, you also have to fight constant time decay of your option. However, if you are on the selling side, you have a mathematical advantage.

As a seller, you make money when the option you sold expires worthless or decreases in value, which is most of the time! Our systematic approach to option selling is based on this advantage and can provide a substantial potential for returns if the proper strategies and risk parameters are used.

(continued below...)

Special Message From Our Author:

Are you an Insider? Get our Futures & Options Guide

The Insider’s Guide to Futures and Options is full of useful information for beginning futures and options traders. Learn how trading works, an introduction and history, explanations of charts used, glossary of terms and much more.

Sign up today for your copy!

There are many strategies one can use when writing options. The ones we prefer to use rely on basic statistics. We believe that the most common pitfall to successful trading is the exit plan.

Too many strategies like to begin by explaining all the benefits of the strategy and how an investor can effectively take advantage of the market. The exit strategy is often an afterthought. This is why we would like you to understand the concept behind the entire trading strategy we employ so you see the exit strategy is built right in and takes the guesswork out of the trading decisions.

An additional pitfall is not being properly funded. There will be losses when writing options. It is imperative to not only have a strategy for managing those losses, but also to have the ability to make the required adjustments without having to worry about margin problems.

There is an old saying, "Bears get rich, bulls get rich but pigs get slaughtered!" We believe in a conservative approach to trading that leaves a majority of the account balance in cash or T-bills.

The Concept behind the Strategy

The first concepts that are necessary to understand are the standard deviation and volatility. A standard deviation is defined in statistical theory as a movement up or down away from the mean, (average), for any group of data.

Each movement away from the mean is defined as one standard deviation. If you have a particular piece of data, say the price of a particular commodities market, you can compare that price to the overall price data of that entire market and come up with specific probabilities of movement over a specific time period. In other words, we can use our computer models to monitor historical price patterns and project potential future price ranges. Our goal is to sell options out of those expected price ranges.

When we sell options, we look at this data and choose options that are overvalued and are two to three standard deviations away from the mean price of the market. Therefore, the probability that the market will hit our price (which we do not want because we are selling premium) is small. If the underlying market price reaches our strike price, we will 'roll' the option to a higher price in an attempt to minimize our loss. That is, if the market hits the strike price of any option we sell, we recommend buying it back at a loss, and then selling option(s) in the same market further away to try to recoup our loss. However, because it is statistically improbable, but not impossible, that a market will move three standard deviations in the time period we have chosen, we will only 'roll' the option twice, and on the third time take a loss.

We can write naked options, or covered options using our strategy. However, there are many other avenues we can take depending on market activity. One such avenue is to sell puts and calls in the same market, otherwise know as Straddle. This, we feel, will increase our statistical chance for profit because the market cannot expire 'in-the-money' on both sides. This means that at least one side will expire worthless, hopefully both sides, when the options go off the board (expire).

In a case where we project that one of the options is not to expire worthless, exposing us to an unlimited amount of risk, then we enter a situation where we have to 'roll' an option on one side of the trade which may result in a loss. It is important to remember that even though we are selling calls and puts for the same commodity the traders who hold these positions are indeed subject to a limited profit potential and an unlimited risk potential.

Option Selling Strategy

Our basic strategy is to attempt to sell an equal amount of call spreads above the market and put spreads below the market to benefit from time decay with minimal market exposure. The trading plan is to sell option premium at approximately 3-5% of the account value each month, depending upon market conditions.

As with all aspects of a trading plan, it is crucial to remain flexible and make minor adjustments to the plan based on changing market factors. It is also important to remember that a trader is subject to margin call as a result of market fluctuations. There may be times when other strategies may provide better risk/reward scenarios and should be considered.

The first 2 to 3 months are a ramping up period because the option strategies we sell will not begin to expire for 30 to 60 days. We will continue writing approximately another 3-5% of the account value each month. As we are writing new options, old ones will be expiring, however there is no guarantee the options will expire.

Therefore, in any given month, we will have overlapping positions. At times you may be holding towards 8-10% of account value, with a recommended maximum not to exceed 16-20%. Even though you may have up to 20% of your account representing naked options does not mean you’re only risking 20% of your account. In fact, even if you sell 1% worth of options in your account you are technically exposed to risk they may result in losing more than what is in your account.

More Special Offers for TraderSavvy Readers

Are you an Insider? Get our Futures & Options Guide

The Insider’s Guide to Futures and Options is full of useful information for beginning futures and options traders. Learn how trading works, an introduction and history, explanations of charts used, glossary of terms and much more.

Sign up today for your copy!

Interested in Options? Check out our Secrets!

Interested in trading Options? We’ll debunk any misconceptions you may have, outline trading methods and strategies the pros use, and give you the tools and information you need to get started!

Sign up today for your copy!

Learn to trade options with Trade Learner!

New to Options? Want to learn how to trade? Get 5 complimentary classes from Trade Learner. These “on-demand” style classes allow you to move at your own pace.

Get your 5 complimentary classes now!

Collecting Premium

Unlike buying options, where the trading account is debited for the cost of the options, sellers have the premiums for the options they sell credited into the account and must maintain a margin to cover any potential losses. Margin rates vary based on market volatility, time until expiration, etc. The exchange actually provides a reduced margin for selling calls and puts in the same market since you can, in theory, only lose on one side at a time. However, a discount on margin is no indication that the risk is limited or that margin calls are not possible.

Another big advantage that option sellers have is that the exchange will allow them to use T-bills for margin, thereby allowing the account to earn interest as well! Traders considering this strategy should allow for at least half of the account balance to remain on the sidelines at all times. By limiting how much of an account is exposed to the markets may reduce the account’s volatility and provide the necessary flexibility to execute the trading plan which is to roll out of improbable trades into more probable trades, but it does not shelter against risk of loss.

Stay Disciplined

It is essential that we stay disciplined and adhere to our exit strategy. The premise of our strategy is taking advantage of the mathematical odds an option may expire worthless ultimately resulting in additional funds deposited in to your account when the written options expire and go off the board.

As the market moves, adjustments will be made accordingly to trades that are losing based on the statistical method discussed previously.

A. If the market ever touches the strike price of the option that we have sold, than we buy it back, (probably at a loss).

B. The strategy, at this point, is to sell another option(s) further away in an attempt to recoup as much of the loss as possible (subject to additional commissions and fees.)

C. We will do this a maximum of three times before the position is closed, depending on market conditions.

The Risk of the Strategy

Unlike other strategies, the Option Selling Strategy exposes a trader to an unlimited amount of risk. The reason is simple, anytime you sell a naked option, Call or Put, the market can move against the option indefinitely thus, exposing the trader to unlimited risk. As an investor it is your duty to become familiar with the potential benefits and hazards of a strategy in which you are considering. Furthermore, this strategy requires additional margin requirements not usually required with other non-risky strategies.

Futures contracts usually carry the most margin requirements compared to options. However, writing options can inquire the same and sometimes more margin depending on how many options a traders sells. OpVest highly recommends traders who are considering this strategy to make sure that he or she has sufficient margin excess while writing options. The extra margin will not only allow a trader to make adjustments when needed, but also reduce their over all exposure to the markets.

Finally, investors should be aware that this strategy is subject to margin calls depending on the market’s volatility and the account’s over all exposure.

Conclusion and Summary

Option Selling if done properly can lead to great gains. However, if an individual is not educated on the risks, the trading plan, and the exit strategy then an individual could lose more then his or her initial investment. If you are an investor who understands the risks involved in this strategy and has the equity available necessary to take advantage of the mathematical odds of options expiring worthless, then we recommend you get involved. This strategy, unlike buying options, estimates where the markets are likely not to go as opposed to where the markets are likely to go and with the current market volatility and liquidity there are countless opportunities for investors to begin selling their options naked!

About Today's Author:

Stephen Salman
Opvest – Option Investments Inc.
800-900-8000 x 220

Steve Salman was born in Montreal, Canada and raised in beautiful southern California. Growing up he watched his father buy lumber for the family furniture business. By 18 years of age, Steve knew the spot prices for Mahogany, Walnut, and Oak. Naturally this led him to his life passion for trading.

Today Mr. Salman is a registered CTA for Avalon Capital Advisors and a branch manager for OpVest. He has been trading for over 15 years and has done everything from being a currency specialist, bond trader, to an options educator. With today’s market conditions, Steve believes diversification and proper money management are required to be a successful trader. Steve currently holds a series 3 and 30 along with being a registered CTA.


View additional market commentary on